Equity Research Report: TCS -Q3FY23

TCS may scale 3900-4700 levels by Mar’23-Mar’24 on higher revenue growths and better EBITDA margin in the coming days

TCS is one of the largest Indian MNC IT service and consulting companies, having its HQ in Mumbai. TCS is part of the Tata Group and operates in 149 locations across 46 countries. Like all other major Indian IT service companies, TCS is also an export-heavy company; almost 95% of its revenue comes from outside India; over 50% of revenue comes from North America, while around 32% generates from continental Europe. U.K. is also a large market for TCS, contributing alone 16% of its overall revenue.

TCS’ software/service is mainly dominated by BFSI (Banks, Financial Services, and Insurance), retail & consumer business (including CPG, travel, and hospitality), communication, media & technology, trading & distribution, and life science & healthcare. IT services: consulting and engineering services, solutions and systems integration, management applications development, outsourcing services, etc. Also, the sale of IT equipment and software licenses is a small part of the TCS business.

Key management:

Board Members:

Key Shareholders: Tata Sons (promoters)

Like all other major IT outsourcing companies, TCS scrip was also under huge pressure in 2022 primarily on the concern of an imminent recession on both sides of the Atlantic (U.S.-Europe) amid lingering Russia-Ukraine/NATO war/proxy war/geopolitical tensions, subsequent economic sanctions, supply chain disruptions of key commodities, resultant elevated inflation, and faster central bank tightening. The market is concerned that if the economy slows down significantly, then big U.S. and European corporates may cut their IT spending, which will eventually affect Indian outsourcing IT service companies like TCS. The same is almost true for other TCS peers like Infy, Wipro, HCL Tech, etc, whose major revenues come from U.S. and Europe.

TCS is now emphasizing reskilling; upskilling, innovations (R&D), and adapting itself to the changing world post-COVID. Like all big tech companies, TCS is also a prime beneficiary of the COVID lockdown-led digital world (WFH) and part & parcel of the ‘K’-shaped economic recovery in the COVID world, unlike the consumer-facing service industry. But post-COVID, there will be less appeal to such a digital theme, although, in some areas, WFH may be a permanent feature for better productivity.

Highlights of Q3FY23 report card: TCS (Consolidated-INR 100 Cr. =1B)

Overall, TCS reported an upbeat and above-market estimate report card for Q3FY23 despite the concern of synchronized economic slowdown/recession on both sides of the Atlantic (U.S.-Europe) and lower tech/digital spending by corporates/enterprises. But the EBITDA margin was lower by -77 bps yearly because of higher traveling & sales cost as physical/onsite meetings with clients and the sales/engineering team started after COVID.

·         Operating revenue Rs.582.29B vs 553.09B sequentially (+5.28%) and 488.85B yearly (+19.11%)

·         Operating expense Rs.426.76B vs 407.93B sequentially (+4.62%) and 345.52B yearly (+20.38%)

·         EBITDA Rs.155.53B vs 245.16B sequentially (+7.14%) and 134.33B (+15.78%)

·         Net interest paid Rs.1.60B vs 1.48B sequentially (+8.11%) and 2.51B yearly (-36.25%)

·         Core operating profit (EBTDA=EBITDA-INTT) Rs.153.937B vs 143.68B sequentially (+7.13%) and 131.82B (+16.77%)

·         Equity share capital Rs.3.66B vs 3.66B sequentially (unchanged) and Rs.3.70B yearly (-1.08%)

·         Core operating EPS (EBTDA/Share) Rs.42.06 vs 39.26 sequentially (+7.13%) and 35.63 yearly (+18.05%)

·         EBITDA margin 26.44% vs 25.98% sequentially (+46 bps) and 26.97% yearly (-53 bps)

·         EBTDA margin 26.71% vs 26.25% sequentially (+46 bps) and 27.48% yearly (-77 bps)

·         Constant Currency (CC) revenue growth +13.5% yearly (y/y) led by North America and the U.K. (+15.4% in CC y/y)

·         USD revenue +8.4% (y/y)

·         Higher revenue in a seasonally weak quarter amid higher cloud computing demand and gains of market share through vendor consolidations

·         Lower employee costs and other expenses helped higher EBITDA

·         The longer-term growth outlook remains robust despite near-term macro headwinds

·         Stress on data analytics, AI, and ML

·         Higher EBITDA margin due to improved productivity, higher USDINR, and fading issues about the supply side (talent acquisitions);

·         FX cross currency headwinds/volatility also affected EBITDA to some extent; around 55% of revenue comes in USDINR., 13% GBPINR, and 11% EURINR

·         IT services attrition trending down; LTM attrition is at 21.3% vs 21.5% sequentially

·         Order book at $7.8B vs 8.1B sequentially

·         Book to bill at 1.1

·         Net headcount addition: -2197; workforce strength: 613974

·         Growth was led by Retail and CPG (18.7%) and Life Sciences & Healthcare verticals (+14.4%)

·         Communications & Media grew by +13.5% and Technology & Services grew by +13.6%. Manufacturing grew +12.5% while BFSI grew +11.1%

·         Among major markets, North America and the UK led with +15.4% growth; Continental Europe grew +9.7%

·         In emerging markets, Latin America grew +14.6%, India grew +9.1%, Asia Pacific grew +9.5% and Middle East & Africa grew +8.6%

·         Growth in Q3 was led by Cloud, Cyber Security, Consulting Services, and Enterprise Application Services

·         TCS’ cloud units continued to see very strong growth led by services for cloud migration and modernization, hybrid cloud adoption, managed services, and governance

Highlights of management commentaries and Q&A (analyst concall):

·         Hired around 7000 fresh engineers in Q3 totaling 135K in the last 6-quarters

·         Our biggest strength is the pool of 125K middle/senior levels experienced engineers, who are with the company for over 10 years, helping to integrate freshers, ensuring best-in-class project outcomes

·         Optimized net headcount after hiring significantly higher in FY21 ahead of revenue growth; now utilizing last year’s excess capacity (manpower) to become more productive

·         The net reduction in workforce in Q3FY23 AT 613974

·         The travel and hospitality segment helped overall revenue amid the holiday season

·         Business health monitoring solution/software ‘ignio’ is gaining traction as enterprises are increasing their investment in AI operations and automation to improve employee productivity, helping overall automation

·         The robust performance of BFSI software BaNCS

·         Satisfactory performance/progress of other software like Quartz (Blockchain platform), ADD (Life Sciences-advanced drug development platform),  Optumera (AI-powered retail merchandise suite), OmniStore (AI-powered universal commerce suite), HOBS (AI-communication services suite), ION (educational/exam suite), MasterCraft and Jile

·         Seasonal factors led to some moderation in growth in verticals like BFSI, retail, Technology, and services

·         Looking ahead 2023 may see a moderation in growth after two years of robust growth amid lingering macro headwinds

·         But clients are also stressing cost optimization using AI and intelligent automation process

·         An uptick in vendor consolidations also helps to win large deals considering TCS’ scale, full services capability, and track record of delivering outsized savings through operating model

·         Clients are also focusing strongly on cloud transformation

·         For the next step of growth & transformations, TCS is now also working with its clients to work in technology-led innovation at the back-end for revenue growth and improved customer satisfaction through predictive analytics, MI & AI

·         Usually, TCS works on G&T engagements focused on the front end, helping clients to launch innovative new products, services, or technology-enabled business models or channel improvements and personalization that enhance customer experience

·         Q3FY23 TCV at $7.8B

·         TCS is now optimizing fresh hiring to improve productivity  and expecting normal attrition levels closer to the long-term average; also open for short-term hires to take care of any unexpected large deal

·         Despite lingering global macro headwinds, no major concern from European and US clients; overall sentiment remains cautiously optimistic

·         The travel and hospitality sector is now booming after 2-years of COVID disruptions; as one of the largest service providers in this sector, TCS is doing well now and expecting to continue that trend

·         The retail segment is mixed as essential cheaper spending (like grocery items) is doing well, but discretionary consumer spending is getting affected to some extent in some areas amid higher cost of living and borrowing

·         As of now, discretionary tech spending by big enterprises is not being affected due to lingering global macro headwinds as it’s helping cost optimization and improvement in overall productivity; but TCS is watching the trend of annual tech spending budget

·         U.S. retail sales may be now moderating amid higher cost of living & borrowing after blockbuster rum rate in 2021-22

·         IT service/tech is an industrial perennial that needs evolving of an enterprise over a cycle, but it’s discretionary

·         Business is transforming for the last five years and COVID accelerated it, which is helping IT service companies like TCS

·         Looking ahead, TCS management is quite confident about the medium to long-term outlook despite global macro headwinds

·         Revenue growth continues to be in the high double-digit in the U.S., while the European/British situation is quite challenging amid Russia-Ukraine/NATO war and macro headwinds (due to heavy dependence on Russian NG and recession in winter)

·         The decision-making process for discretionary tech spending for improving overall productivity is traditionally slow in the EU/Europe except in the U.K., where it’s very fast and clear, while in the U.S. is normal. But everybody is cautious right now for the time being; TCS thinks by Q1CY23, the overall macro situation will be clear

·         Overall, TCS management is quite confident about high double-digit growth in the medium to long term

·         Continental European business returns to double-digit growths once Russia-Ukraine geopolitical tension comes down (around +9.7% in Q3FY23)

·         U.S.  and U.K. businesses should maintain high double-digit growths (around +15.4% in Q3FY23)

·         The company may also opt for another buyback in FY25 apart from the current buyback and higher dividend policy; i.e. company is providing higher shareholder return and at the same time maintaining free cash flow (as per company methodology) at around 80-100% of net profit as earnings growth is above +15% (in INR)

·         Cloud adaptation, transformation, and cost management are now themes of the IT services

·         In EMs (including China and India), digital adaptation is gaining momentum in banks & financials including insurance and capital market

·         Travel costs are increasing as normalcy returns after COVID; also sales-related costs, team building exercises, and physical team meetings are happening; so costs are increasing to pre-COVID levels

·         Expecting CY23 IT spending budget from U.S. corporates by Feb’23

·         Aspirational EBITDA margin target of around 26-28%

·         Sees muted prospect in manufacturing industry growths amid lingering supply chain and energy price disruptions

·         Also cautious about the retail industry amid lingering macro headwinds

·         The strategy is to stay close to the client to understand the dynamics of their business process, but clients are also cautiously optimistic

·         TCS is cautiously optimistic about the overall macro and business situation, especially in Europe

·         Q3FY23 (Oct-Nov-Dec) is seasonally weak for severe winter and holiday season

·         No visible slowdown in tech spending in the U.S., the largest market of TCS

Finally, TCS CEO Gopinathan said in his concluding remarks:

“We are pleased with our performance in a seasonally weak December quarter, growing at 19.1% in INR terms and 13.5% in constant currency. Our order book was good, but softer than in the prior quarter, reflecting the cautious stance that many of our clients have taken. Our operating margin expanded sequentially to 24.5% and our net margin was at 18.6%. On the people front, LTM attrition in IT services fell slightly to 21.3% and should continue to taper down in the quarters ahead”.

Fair Valuation: Rs. 3256-3908-4689-5627 for FY: 23-26

TCS and also other big Indian IT service companies (exporters) are big beneficiaries of digital transformation by big global corporates to stay ahead of the competition and inflation curve (higher input costs). Indian IT exporters are also benefitting from the weak Rupee despite some cross-currency headwinds and higher employee & travel expenses (post-COVID).

TCS reported a core operating EPS of Rs.142.82 in FY22 against 124.08 in FY21 and 109.83 in FY20. Now considering various pros & cons, current & past run rates, and FY23 guidance provided by the company (15% revenue growth and 26% operating margin in CC), TCS may report at least 14% growth in core operating EPS in FY23 and subsequent 20% average CAGR in FY24-26. This will translate to a projected core operating EPS of around Rs.162.82-195.38-234.46-231.35 from FY23-26. Now assuming an average core operating PE of 20, the fair valuation of TCS may be around Rs.3256-3908-4689-5627 for FY23-26. As the market always discounts at least one year's earnings in advance, TCS may scale 3908-4689 and 5627 by Mar’23-Mar’24 and Mar’25.

TCS is a key beneficiary of higher tech/digital transformation spending on enterprise growth & transformation (G&T) initiatives. Despite the chorus of the synchronized recession on both sides of the Atlantic (U.S.-Europe), TCS is cautiously confident about demand and ongoing technology spending by big corporates as they have to stay competitive and relevant. TCS does not see any meaningful softness in demand/new prospects or delay in the decision-making process by big corporates despite the uncertain macro environment and the chorus of synchronized global recession/stagflation amid adverse geopolitical situation (Russia-Ukraine/NATO), economic sanctions, elevated inflation, and faster tightening by Fed, ECB, BOE and all other top G10 central banks.

Rising investments in areas from cloud computing to cyber security and digital transformation by various corporates during the COVID pandemic have propped up demand for the $195 billion Indian IT industry. However, the demand has also led to severe attrition among employees and margins have suffered due to higher employee costs like wage hikes and additional travel and visa costs (after COVID). Thus managing employees; i.e. attrition is now a huge challenge for Indian IT service companies like TCS. But the hybrid model of work should also optimize operating costs and improve productivity/employee satisfaction; i.e. will eventually reduce attrition.

For TCS, the operating margin should improve in H2FY23 amid the normalization of salary hikes, moderation in attrition, and better pricing. This coupled with higher USDINR may support all IT service exporter earnings including TCS in FY23. TCS is also aiming to double its revenue in the next few years on a sustainable basis and partnering with various big corporates in U.S. and Europe for their digital transformation journey. TCS has a strong, debt-free and cash-rich company. Looking ahead it can grow multifold through various organic and inorganic expansions and also growing digitalization theme in India (both at government and private levels).

Overall, TCS is a major beneficiary of global inflation/macro headwinds as companies are now embarking on cost-cutting/optimization by adopting greater automation and digital and cloud adaption. The market was skeptical about TCS’ performance amid the synchronized economic slowdown on both sides of the Atlantic (U.S.-Europe), TCS’s primary market. TCS said although there are some concerns about discretionary long-term high-tech spending, most companies are now upgrading their techs for cost optimization and to stay ahead of the curve/competitors.

Recently Google parent Alphabet announced around 12K job cuts in the U.S. and various other countries to cope with slowing business revenue amid the chorus of a synchronized global recession. Techs such as Meta, Amazon, Microsoft, Alphabet (Google), and Tesla jumped on hopes of better earnings after mass layoffs. Various other big techs are also laying-off ‘unnecessary’ employees in masses to cope with the muted operating revenue as COVID-era digital spending growth fumbled after the pandemic has turned into endemic coupled with overall slowing economic activity amid higher inflation (cost of living) and higher borrowing costs. The discretionary digital spending is being affected, resulting in muted fresh digital capex. But techs are recovering now in hopes of cost optimization amid mass layoffs. Here in India, big IT firms such as TCS, INFY and Wipro are also in the process of employee cost optimization in a prudent and calibrated manner without creating a panic.

Fed is now preparing the market for terminal rates around 5.25-5.50% and stay there until at least Dec’23 or Mar’24. And Mar’24, if core PCE inflation stabilizes around +2.0% targets, and unemployment goes up around 4.5%, then Fed may also go for some rate cuts and even launch QE-5 ahead of Nov’24  U.S. Presidential election to have a ‘feel good’ factor for both Wall and Main Street. As the market will begin to discount this scenario after H1CY23, bond yield may go lower and techs higher.

Technical view: TCS (for short-term trading/investment purposes)-CMP: 3415 (23/01/23-EOD)

Looking ahead, whatever may be the narrative, technically, TCS now has to sustain over 3500 areas for 3610/3835-4000/4050* and further 4090/4125. On the flip side, sustaining below 3480-3425 areas, it may again fall to 3345/3280-3225/3160* and further 3000/2915. Investors/short-term traders may now either buy above 3500 or on correction around 3160-2915 zones which may act as a strong demand (accumulation) zone.

TCS: Consolidated P/L A/C (QLY): Q3FY23

TCS: Consolidated P/L A/C (YLY): FY22

TCS: Consolidated B/S: FY22

TCS: Consolidated cash-flow

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